Target Date Funds 3.0

Mark Yamada | October 9, 2009

Shortly after takeoff from Heathrow, the pilot’s voice crackles through the cabin.

“Flying at an altitude of 35,000 feet, our time to New York City will be 7 hours 56 minutes. Stronger than expected head winds are possible so we may be landing up to 1,200 miles short of the airport. Nevertheless, we are pleased to offer you another ‘on time’ arrival!”

Such is the case with today’s crop of “target date funds” (TDFs) that change their asset mix on a predetermined “glide path” towards a specified future date. As with our pilot, adverse market head winds can ditch unit-holders and passengers in the ocean, short of their destination. That’s exactly what happened in 2008 as 31 funds in the U.S. with 2010 targets averaged losses of almost 25% with slim chance for recovery.

Problems with TDFs in the U.S. have drawn the attention of the Securities and Exchange Commission, the Department of Labour, and a Senate Financial Services Sub Committee. An inability to benchmark or to communicate the risk range assumed by unit-holders continues to shadow the product.

Target Date Funds 1.0 First generation target date funds address most DC plan member’s aversion to investment decision-making. Plan sponsors acknowledge that investors often feel unqualified or lack the time and motivation to address an abstract-distant event like retirement. Consequently, over 80% of plan members select default options in the U.S. and U.K., according to a financial journal. Critically, TDFs are becoming a popular default option around the world, including Canada.

TDF 1.0’s predetermined asset mix changes vary, but each manager has a fixed “glide path” that shifts from mostly equities in long dated funds to mainly fixed income and cash equivalents later on. But their glide paths are determined by the target date and ignore the risk tolerance of the investor. Thus TDF 2.0 was born.

Target Date Funds 2.0 TDF 2.0 recognizes that not all investors are the same. Rather than focusing on each investor’s pension solution, the industry’s response is simply to add “conservative”, “moderate” and “aggressive” or other risk variations to each TDF.

The biggest problem with TDF 1.0 and 2.0 may not be the aggressive asset mix in near dated funds, but that they don’t deliver what investors really want and need; reliable replacement income in retirement.

It’s about the investor Is it sufficient to provide declining risk over time? Should the investor’s current funding status be considered when determining target risk?

In common TDF schemes, the portfolio is rebalanced to progressively more conservative asset mixes ignoring the realized market experience of fund participants. Over-funded plans following a roaring bull market and under-funded plans in the wake of a bear market are treated to identical glide paths.

Conclusion Customized portfolios that automatically manage risk and deliver reliable income in retirement for each member is the “holy grail” of DC plans (with apologies to fans of the guaranteed minimum withdrawal benefit). While the idea of a private jet for each plan member seems extravagant, advances in technology and liability-driven investing make mass customization a possibility. The solution requires more than what investment professionals alone can offer. Plan administrators may have to rethink their systems’ architecture and approach.

Target Date Funds 3.0 is about the investor. Better solutions are not only possible from tailored portfolios but liabilities may be effectively mitigated as well. Plan sponsors seeking low cost/low hassle solutions can now deliver something investors want, a better chance at reliable retirement income.

Getting to a chosen destination on time, with your own luggage, is what the retirement journey should be all about. Target date funds 3.0 promises to do just that.